June 19, 2024 • 39 mins
Shiloh Bates talks to Nomura Securities CLO Researcher Paul Nikodem in the sixth episode of The CLO Investor podcast. They discuss the process of evaluating CLO managers and also tackle the topic of declining CLO financing costs.
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Episode Transcript
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(00:03):
- Hi, I'm Shiloh Beat
and welcome to the CLO Investor podcast.
CLO stands for collateralizedLoan obligations,
which are securities backedby pools of leverage loans.
In this podcast, we discusscurrent news in the CLO industry
and I interview key market players.
Today I'm speaking with Paul Nicom,
(00:24):
CLO researcher at Mura Securities.
Paul's job is to provideCLO market commentary
and analysis to CLO investors like myself.
Our primary discussion revolved
around evaluating CLOmanagers at Fire Rock.
We do not manage CLOs, wejust invest in CLO Securities.
Each CLO has a manager.
Their job is to pick the loans for the CLO
(00:47):
and to keep the CLO passing.
Its many tests according to Credit Flux.
The five largest CLO managers are Elmwood,
credit Suisse AssetManagement, Blackstone,
Neuberger Berman, and Octagon.
But CLO investors have overa hundred different managers
they can choose from Ourconversation also tackled declining
CLO financing costs.
(01:08):
And now my conversation with Paul Nico.
Paul, welcome to the podcast.
- Thanks, Shiloh. It's good to be
on. Appreciate you having me.
- Why don't you tell ourlisteners a little bit about your
background and how someonebecomes a CLO researcher? Sure.
- To be honest, I didn'tstart off as a CLO researcher.
(01:29):
I've been covering securitized products
as a research analyst since 2003,
but I started my career covering mortgages
and housing for the first decade.
So it was a really interesting time
to cover both of those markets.
Obviously saw the large runuppre global financial crisis
and then the whole mortgage market
and the housing market imploded
and then that was followedby the recovery trade aided
(01:50):
by a lot of government support
and just a slow rebuildof the mortgage market.
So it was a really interestingtime to think about scenarios
and how to stress bonds andjust experience both the boom
and the bust cycle.
And then after 2010
or 2011, it was really the recovery trade
where we saw government support come back
to the housing market and private capital
(02:10):
and really start to slowlyexpand the underwriting box.
And the mortgage market slowly came back
until the housing market accelerated
and then it was boom timesfor much the next decade.
So as we covered RMBS
and housing during that decade post GFC
and we expanded our coverage,
we started looking at other sectors
as well within the securitizedproducts research arena.
(02:32):
One of the sectors that stoodout to us was the CLO sector
that was starting to gain its footing
and starting to growpretty rapidly at the time.
And it was really interestingfor us as research analysts
to look at the performance during the GFC.
Now, the mortgage marketclearly did not do well
and it was really housing led,
but CLO market did quite wellsurprisingly well when we
(02:53):
started looking at the data.
And it was really interesting to see
how these structures held upin this first stress scenario
that we started to take a look at.
And basically around that time,our firm Nomura also decided
to make a commitment to growin the CLO business, starting
with the secondary trading
and followed by theprimary business as well.
And we started to cover the sector from a
(03:13):
research perspective.
So the idea was that wehad really great technology
that we built up from theresidential mortgage research
arena looking at loansand mortgage servicers
and intext data.
First thing we did is wetook a look at those systems
and applied them to the CLOmarket where we had managers
and we had individual loan issuers.
We tried applying similar technology
(03:35):
to see what we can find.
And it was a reallyinteresting time to start
to look at a very microlevel at the CLO market
to see differences in manager performance
and loan performanceand issuer performance.
And that's how we got started.
We were in the rightplace at the right time
and we were able to transfersome of that technology from R
and BS to really hit theground running on the CLO side.
And since then, the market hasobviously grown dramatically.
(03:57):
It's one of the key sectorswithin the securitized markets,
and it's very fascinatingto look at the market,
both from a very macro perspective
where we look at the buyerbase and overseas investors
and just supply demand dynamics
and also at a very micro levellooking at manager selection
and loans and recoveries anddrilling in very, very deep.
So it's been a very exciting time
to be a CLO research analystover this past decade.
(04:20):
- So for your research, is it
that you put out a differentpiece each week that goes
to a number of clients tellingthem whatever you think is
interesting that'shappening in the market?
- Exactly. So we try to respond to
what questions are oninvestors' minds at every week,
sometimes more frequentlythan once a week depending on
what's going on in the market.
But we try to combine some
of the micro interesting data analysis
(04:41):
and manager analysis with some
of the broader macro observations
that we find in our research.
- I know Nomura has a CLO banking team
and a CLO trading team.
Why don't you talk about the other things
that Nomura is doing with CLOs?
- So starting in 20 15,20 16, we started off
by having a very strongsecondary trading effort.
So our firm is the mostactive trading desks in most
(05:04):
scenarios in Double BS and equity
and me in general, we speakwith all the key investors
that are active in the space
and we have a very strong franchise there.
A couple years later,
we also made an investmentin the primary business
where we deal with many of the largest,
most established managers in the space.
And we've really built a top10 business in that space.
So part of it is timing andgetting the timing right.
(05:26):
Part of it is investing in talent
and investing in balancesheet as well as research.
So our firm has really decided
to make an investment in this business.
- So what is it about CLO equity
and CLO BBS that's of particularinterest to your firm?
- It's a very data intensive,research intensive product
where there's a lot of differentiation
(05:46):
and performance across managersand deals and vintages.
With the right tools in place
and the right investment inplace, we have developed a way
to find a niche and an edgein identifying opportunities.
There's a lot of dispersionin performance, so that's one.
These products trade verydifferently depending on the
profile and requires a lot of analysis
and insights into themarket to figure out how
(06:07):
to generate alpha for our clients as well
as run a successful trading business.
And part of it is connectivityto our primary business
as well, where a lot
of what's going on in themarket today has to do
with optionality for issuersand equity holders to refi
or reset or call these deals.
So having an insight into
what investors wannado both on the primary
(06:27):
and the secondary side
and what are the outs for thesedeals has a large impact on
valuations, especially given that most
of the market is trading at a premium now.
So the timing of that refirereset is also crucial.
We feel like we've developedan edge in that as well.
- Interesting. So oneof the things I wanted
to focus on today was justhow to evaluate A CLO manager.
(06:48):
So if we're talking aboutbroadly syndicated CLOs, which is
around 90% of the market,
I think there's a hundreddifferent active CLO managers.
What do you think the firststep is in identifying a CLO
manager that's gonna outperform
- From a research perspective?
We've developed a large variety of metrics
to evaluate manager performanceover a long period of time.
(07:09):
So in the past, I'd say
that par bill was the mostrelevant metric that we used.
- Note par build refers
to the CLO manager growingthe par balance of the loans.
This can sometimes bethought of as loan gains
- To benchmark and comparemanager performance over a
long period of time.
Although in recent months
and quarters, it's becomea less useful metric
(07:31):
by itself even though a lot
of managers have beenfocused on risk reduction
and defending against tails,whether it's downgraded loans
or lower price loans picking up.
And the stats have beenskewed based on the
par build metric alone.
So we've done a couple of things to try
to identify who'soutperformed in recent years.
Number one is we've tried
to improve on the par build metric.
(07:52):
And what I mean by that iswe've created a new sub metric
within par build to try
to decompose the two effectsthat drive par build.
One is original portfolio quality
or credit selection, how has
that original portfolioperformed over time,
absent any subsequent trading activity
and also the value add of trading.
So we have a metric, we like
(08:13):
to call it active versuspassive par build.
So we decompose thatperformance by manager.
That gives a lot of interesting insights.
First being that originalcredit selection matters a lot
more than trading activity
and driving performance
for many managers over the past two years.
So that's one observation thatwe rely on from this metric.
- So is what you're saying herethat the CLO begins its life
(08:34):
with 400 million or 500 million of loans
and it's really thatinitial loan selection
that's gonna be the key driver
of returns over time? That's your view?
- In the last two years,that was the primary driver
of differences in performance,
not necessarily true inprevious episodes of distress,
but over the past twoyears, definitely the case.
Another thing is looking athow CLO managers manage tails.
(08:57):
So on the surface you couldtake a look at what's the triple
C concentration by manager,
and that's one thing thatthe market does tier for.
But looking under thehood, there's some managers
that don't sell a lot of triple Cs
and they might have acredit view that some
of these loans might recover
and the market pricesare too low at the time,
and you have other managers that might be
very aggressive in selling.
And then you also have the other dimension
(09:18):
of high downgrade rates to triple C
and lower downgrade rates to triple C.
So I think it's also veryimportant to decompose
and think about what aredowngrade rate differences across
managers and how does thatinteract with trading as well?
So sources of triple C
and how managers are handling that
through the cycle alsomatters quite a bit.
And finally, just thinking more broadly,
(09:39):
consistency matters quite a bit.
So in terms of thinking aboutwho's done well in the past,
there's obviously no guarantee
that past performance willlead to future success.
So we like to look over a longtime period at consistency
throughout different cyclesand consistency and style.
But for example, some metrics we like
to take a look at are unleveredreturns on the underlying
(10:00):
portfolio over time.
So how does it look everycalendar year going back five
or 10 years depending on the tenure
of managers we're taking a look at?
So consistency is important.
If you're a debt investor,you do not wanna see large
drawdowns necessarily equity investors,
you might have a littlebit more tolerance for
that if you see moreupside in certain years,
but it all depends on whereyou sit in the capital stack.
(10:20):
So consistency in generalmatters quite a bit
as we think about forward outlook.
- So one of the things fromI see is that the metrics
that you used, I couldobviously see the attractiveness
of using them, but eachmetric is a little bit
incomplete in some way.
So for example, you mentionedthe par balance of the loans
and is it growing?
So the shortfall of thatmetric is just, well,
(10:43):
are the loans price at paror 90 or some other number?
And then if we're lookingat triple C balances,
triple C loans are certainlyat higher risk of default.
But one of the first experiencesI had with CLO managers,
I went to a prominent one
and he was telling me abouthis philosophy on triple CCCs
and he just basically said, Hey listen,
(11:04):
I'm just buying good loans for the CLOs.
And if a rating agencyhas a loan at triple C,
it's important to know thatfor the functioning of the
CLOs many tests.
But at the end of the day, he is like,
I just wanna buy good loans.
He trusted his credit team alot more than the rating agency
assessment of the risk in the loan.
And he told me he mightbuy a triple C loan
(11:26):
because it has a high spread or
because it has a low dollar price.
So sometimes the rating agenciesare a little bit lagged in
terms of their downgrades or upgrades.
So that's the downside tousing the triple C balance
as a prominent metric.
And at the end of theday, really the question
with triple Cs are justare they gonna repay at
at par or not?
(11:46):
- Yep, exactly. I think that'svery consistent with a lot
of our thoughts as well.
I think that speaks tooriginal credit selection
mattering a bit.
And obviously you wanna have amanager that's at least aware
of some of the triggers and tests
and the structural constraints
of A CLO versus just managinga loan portfolio as it relates
to certain stress scenarios
or the ability to have goodmetrics so that they're able
(12:07):
to continue to raisecapital in the future.
But at the end of the day,I completely agree it's loan
selection and having agood credit team definitely
matters quite a bit.
Those with better selectionability over the last couple
years have definitelyoutperformed in our metrics versus
those that might be optimizingpar build, for example.
- So I think the first cutfor any CLO manager analysis,
(12:29):
what we would do is justpull up their deals and Intex
- Note Intex is softwaremarket participants use
to model CLO securities
- And look for deals thatare two to three years old
and see what's happeningwith the loan portfolio.
And really just askyourself, are these CLOs
where I would've wanted toparticipate from inception?
(12:50):
I think that's a good wayto start the analysis.
One of the things that Ithink is everybody's looking
for the loss rate on the loans.
So one manager might have 40 basis points
of annualized loan losses,another might have 60
and somebody say, okay, wellthe 40 is better than the 60,
but what you really need todo is normalize for the income
(13:14):
or spread of the loans.
So if one CLO managerhas a 20 basis points
of incremental loan losses,
but their loans provide 40 basis points
of incremental loan income, then
that's the better manager in our view.
- For equity holders. That's definitely
a valid way to look at it.
I think that, for example,
our unlevered return metrichandles that maybe not directly,
(13:35):
but it goes in that direction
where if you have a higherspread on the portfolio that'll
contribute to the returns
and be offset against themarket value drawdowns.
So we don't explicitlycount defaults separately
from market value moves.
It's counted together. Andthat's a very good point
for equity that you have somemore cushion if you have a
higher spread portfolio.
So yes, absolutely, I would
definitely consider that as well.
(13:55):
- If you were just gonna use one metric
and one metric only toevaluate a CLO manager,
would it be the unleveredreturn of the loans first,
the Morningstar loan index?
So that's just the performanceof the loans outside
of the CLO structure
- Over the long term in terms
of identifying upgrade candidates
and just thinking bigpicture. Yes, absolutely.
(14:17):
- So I mentioned earlier thatthere's downsides to each way
of measuring performance,
and if you're looking at theperformance of the loans only,
you're not capturing anyof the skill that's needed
to manage CLOs and the CLOs.
Many tests. And then also someCLO managers are just gonna
have more conservative loan portfolios.
(14:38):
So those might underperformthe Morningstar loan index,
but with the leverage
provided by the CLO structure,
the returns there couldstill be quite favorable.
- Yep. I mean, one thing Iwould say for that is we tend
to look at a cluster a two bytwo scatterplot, if you will,
of returns versus standard deviation
of returns versus some other risk metric.
We've played around with a fewto risk adjust those returns
(15:00):
to do some comparative analysis.
So for the higher return,
lower standard deviationmanagers look at a quartile,
for example, on this two by two grid,
which managers areoutperforming their peers.
I agree with you. On averagethere are some biases
to looking at it that way
and it might not fullycapture the equity returns,
but we're thinking more interms of upgrade candidates
or which smaller managersare outperforming some
(15:22):
of their bigger manager counterparts
and are deserving of anupgrade for equity managers.
I think that definitely wouldlook at different metrics more
so in terms of leverage anddistributions and cushions,
but that unleveled returnversus appears is more
for a holistic view on upgrade potential
and small versus big managers
and who's trending in what direction.
(15:42):
- So maybe the takeaway isjust that there's a number
of different ways to evaluate CLO managers
and you probably need to use all of them
to really get a complete picture.
So the result of CLO manageranalysis is a tiering
of CLO managers into tier one through four
with one being the best.
So I think starting at tier four,
(16:04):
would you put anybody in tier four?
I'm not necessarily lookingfor names at this point,
but are there a handful of managers
that have really underperformed
- In terms of underperformance?
Yeah, there's probably isn't a quarter
of all the managers outstanding.
It's probably not the bottom quartile.
Maybe it's the bottom decileof, as you mentioned, managers
that haven't issued andsome of them might be trying
(16:25):
to rebrand themselves andhave much cleaner portfolios
and switch their style, butthere's definitely a few
that clearly haveunderperformed in the past
and clearly have par holes
or underperformed duringpast stress periods
that are just not treatedwell in secondary at all.
There's stats reflect that.
The other tier is justnew managers in general,
which we give them thebenefit of the doubt
(16:45):
and wait two to threeyears to see a track record
before really taking on a view.
To your point earlier
that everything looks clean on day one,
but it seems like it takesat least two to three years
of history before we couldstart to differentiate
who are the better and theworse of the new managers.
And basically who deservesan upgrade to tier one
or tier one and a half faster than others.
That's how we're thinking about it.
(17:07):
- Okay. So who do you thinkis in the top tier if you're
able to share a few names with us?
- Sure. So top tier
and the way we think about itinternally, there's a couple
of different metrics,whether you're the top,
you're the bottom of the stack,part of it's performance,
part of it is a UM, partof it is number of deals
and primary spread tiering,
and it's a little bitof a circular argument.
(17:27):
We don't really love it as research folks,
but it makes sense thatmanagers that have been
around longer who haveconsistently traded tight primary
have better liquidity.
So there's a better refi reset optionality
to get out if spreads tightenwithout as much extension risk
and they're gonna tradebetter in secondary if you see
another covid scenario andspreads blow out, for example.
(17:47):
So there's some self-fulfillingprophecy to that.
Our first blush would just be to rank
by primary spread tiering aswell as just a UM in general.
So you'd see a lot ofthe usual names there,
but to put a couplenames out there in terms
of overlaying a researchview on performance
and who's been cleaner
and who's navigated throughcredit cycles better than
others, some names that standout within that tight spread
(18:09):
and high a UM top quartilewould be, for example, Elmwood,
CSA, Oak Hill, I guess BlackRock, CISC,
Allstate are some names that come to mind.
- So do you think that mostpeople in the market would agree
with the tier one distinctionfor the guys you mentioned?
Or is it that CLO investors like myself
that we are just using totallydifferent inputs into our CLO
(18:32):
manager analysis that wouldresult in a different tiering?
- So at the top of the stack,
I think it's prettyself-evident given the A UM
and primary spread tiering,which tends to be very sticky.
And part of it has to do with the fact
that larger anchor buyerstend to just set up their list
and they tend to switch less frequently.
Although we have seen ashift in the AAA buyer base.
(18:54):
So there's some impetus for change,
although not as rapidly asat the bottom of the stack.
So at the double B
and at the equity part of the stack,
I think there's a lotmore opinions, especially
of if a manager hastails that are increasing
or has cleaned up quite a bit,the market could tier very,
very differently pretty quickly
after seeing some of theperformance differences.
Or they might tier a manager differently
(19:16):
for vintages two years agoversus four years ago based on
differences in performance.
So it feels like down the stack
that tiering is a lot more responsive
and there's a lot moreopinions about who's improving,
who's trending, who'sgetting worse, et cetera.
- So from my perspective,
it looks like a tier onestatus at the top of the stack.
For the aaa for example,a lot of that seems
(19:37):
to be just based on namerecognition rather than the
performance of the underlying loans.
And once you have thattier one AA investor base,
I think it tends to be pretty sticky.
So these guys just continue todo your deals year after year
and maybe aren't looking toput new entrants on their list.
And in CLO equity is totally different.
So you're bearing any loanlosses, it's an issue for you.
(20:00):
So name recognition doesn'treally pay the bills.
The other part of CLO manager tiering
and manager selection is just
that there could be managersout there that we really like,
but at the end of the day,
if they can't get good debt execution,
then there's really nothingfor us to talk about
because that's the key ingredient
for good CLO equity returns.
So Paul, let me ask you this.
(20:22):
It seems like every year there's five
to 10 new CLO managerentrance to the market.
Have you seen any of thosebe particularly successful?
I think it's a pretty tough business
to break into. Actually,
- This may not be the newest of managers,
but Elmwood was probably thefirst one that stuck out.
Obviously the PM came from BlackRock
and the performance waspretty similar early on
(20:43):
and conservative, butthey've performed very well
and are clearly tier one
and nobody would call them a new manager,
but they're probably thefirst one that we would think
of in terms of that upgrade cycle.
But more recently, I guessBirchgrove white box stand out
to us as also going downthat positive trajectory.
- So one of the changeswe've seen in terms
of CLO management style is
(21:04):
that pre covid managerswere doing loans with
LIOR spreads from 330basis points all the way up
to 400 basis points.
And during covid, when loanlosses were elevated, a lot
of the loan losses wereactually in the high spread
names, which makes sense.
So it was really theconservative loan pools
(21:25):
that outperformed during covid.
And it seems a lot
of CLO managers arereally now just sticking
to the lower spread pools.
Is that something you'reseeing in your research?
- I'm hearing more of the latter,
but as a research analyst,another thing that I point out is
that a few years ago,
if you take a look at a scattered plott
of was versus performance
- Note was stands for, theweighted average spread
(21:47):
of the loan portfolio
- High was tends to outperform.
In good scenarios, theytend to have large drawdowns
and bad scenarios, unsurprisingly,
but more recently, over the past two years
that correlation has broke down
and it's not obvious
that high loss hasunderperformed in the cycle.
In fact, we've seen somelower spread managers
that have had a small numberof loans that have gone bad,
(22:10):
and unfortunately therecoveries have been so low
that they've taken pretty big par hits.
So the correlation betweenhigh and low spread
and performance has reallybroken down in recent years,
and it's hard to reallyshow that relationship.
Recently just giventhe market environment,
the defaults have been low
and just the loan recovery hasbeen just very idiosyncratic.
So anecdotally, it does feellike we've seen a number
(22:32):
of higher spread managerspreviously that are trying
to go into lower spread,
more conservative portfolios rather
than the other way around.
But it's not clear thatthat has a difference,
an impact on performance as
of right now over the longerrun, in theory it's supposed
to have a correlation, but inthe last two years it has not.
- Well, one of the reasons
that we favored the lowspread loan pools was that
(22:54):
with the low spread portfolio,
you can still generatevery healthy distributions
to the equity, but you'retaking less risk on
the underlying loans.
And if the loan poolstays strong over time,
then you're the optionvalue of doing resets
and refis in the future is greater.
Whereas if you just have thehigher spread portfolio, that
(23:18):
to me implies more risk
and the higher spread, theloans do create more income
for the CLO equity thatcomes quarterly and
and of course that's nice,
but you don't really need toreach for the higher spread,
spread the loans to getvery good CLO equity returns
is is our view.
(23:40):
- Yeah, I think that makes a lot of sense.
I remember I think five
or six years ago, this iswhere we saw a switch where
before that the lower spreadmanagers didn't necessarily
have great distributions
and a lot of them wereshunned by the market.
But after that there startedto be a transition where some
of the lower spread managershad really tight funding costs
and they avoided a lot of the hiccups in
20 17, 20 18, 20 19, whether it's retail
(24:02):
or some of the idiosyncratic issues
that showed up in the loan market.
And they reallyoutperformed, at least some
of them started outperform.
And I think that trend has continued.
So I think that makes a lot of sense.
- So changing topics, one
of the things we've seen this year is
that the COO financing costs have come in
really dramatically.
And curious if you thinkthe trend's gonna continue
(24:24):
or if there's some floorlevel to SEAL Lewis spreads
that we may hit at some point?
- That's a great questionthat we often have
received recently.
I feel like spreads willcontinue to oscillate down,
but the issue is that everytime you tighten a few bips,
you could see another wall ofrefi reset supplied pickup,
and that could temporarilycause spreads to widen
(24:45):
before they tighten again.
But the general directioncontinues to be tighter.
So across all thesecuritized products assets
that I cover now,
the conversation is reallyspreads are pretty close
to post pandemic tightsor near two year tights.
And now take a look at where spreads were
before the pandemic andlook at that comparison.
And CLOs are not in a vacuum by any means.
(25:05):
I don't think that there'sanything preventing CLOs
to go into the low to midone thirties by year end
with a couple of fits
and starts where spreadsmight temporarily widen
with refi reset supply.
But there's a couple ofimportant factors here.
One, just from a broadermacro environment,
we think the macro environmentwill be relatively benign
and fund flows will bepositive and insurance
(25:26):
and annuity flows will be positive.
And more importantly, bank demand
for securities has gradually picked up.
And we think that trend willcontinue going into year end
positive for CLOs justgiven the duration profile
and the floating rate nature.
But I think all the majorinvestor groups are either
investing quite a bit
or rising as a share of buyersin terms of the CLO market
(25:46):
and broader securitized products.
Also, net issuance isvery, very limited for CLOs
and even more limitedfor triple eight given
that amortization speeds are elevated
and most of theamortization happens at the
AAA part of the stack.
So to give some context, CLOAAA net issuance is barely
above zero year to date,
whereas overall CLO net issuance is about
(26:08):
15 billion year to date.
So the net amount of growth
and the AAA part of themarket is pretty close to flat
and that'll probably continuefor the remainder of the year.
Taking a look at some of the bank data,
banks have been roughlyflat to down in terms
of their holdings over the last quarter
and they could pick up a little bit.
ETFs obviously are growing
and accelerating, especiallyat the top of the stack,
(26:29):
and it doesn't take much of ETF
or bank flows to reallypush aaas tighter given
that they're not really creating new aas.
A lot of it is recyclingfrom short to long
and amortization.
But in general, we think thetechnicals should be positive,
think the macro environmentshould be positive.
We think the Fed first ratecut, we're calling for July
with some risk that itgets pushed to September,
(26:50):
but we're calling for two cuts this year,
possibly slightly less, butat least one cut this year.
Even if some of the inflationprints are a little bit hotter
in the near term, it does feellike a risk on environment
and general spread tightening environment.
So we are positive at the top
of the stack continuing to tighten.
- Do you think that spreadtightening is really a function
of the fundamental performanceof the underlying loans
(27:13):
or is it more technical in nature?
- I think it's verytechnically driven recently,
so a year ago agency spreadsat 180 bips was certainly an
impediment to CLOs tightening given
that you saw some crossoverbuyers look at both,
that issue has gone away.
Agencies have tightened in quite a bit
and we think they are slightly below
where fair value is right now.
(27:34):
So that's one. The technical environment
of issuance is very, very limited
and the buyer base hasexpanded tremendously.
Used to be a couple ofanchor buyers in Japan
and a couple of domestic banks
sponsoring the majority of deals.
Now you have deals that are syndicated,
you have money managers, youhave insurance, you have ETFs,
so you just have much more players,
especially in retailsponsoring the sector.
(27:55):
And on the fundamental side,
we see no issues at theAAA part of the stack.
It's as positive as ever.
So we think that all signspoint to continue tightening
- Well.
I think the higher base ratehas certainly attracted a lot
of people to our market,the science CLO equity.
The other really important security
to me is the CLO double B.
So by our math, there'sbeen about 25 basis points
(28:17):
of annual defaults thereover the last 30 years.
And s and p publishes a stat on that.
I think there's about 35 different
names that have defaulted.
So it's a pretty small number.
Given the size of the overall market.
Do you think that thefavorable risk adjust returns
of BBS will continue here
or is there any reason to think
that the default rate will pickup from the 30 year history?
(28:40):
- We're very positive on double Bs.
We think it's a very stable structure.
We don't think that defaultrates will materially pick up.
Obviously there's a manager bias
where if you take a lookat some of the deals
that have taken write downs
or have not paid principal in the past
or have been downgraded todefault in the past, they tend
to be some of the smallermanagers, maybe managers
that have taken on more of the risk,
but not necessarily in thelarge top tier managers
(29:03):
that have had more of a defensive posture
and an active trading posture in general.
So overall on a modelbasis, it's extremely hard
to break double Bs.
You need to annualize thefall rate of at least five,
maybe seven or 8% per year
for life depending onyour other assumptions.
And it's like a GSC scenarioextrapolated multiple times,
but we know that averagesdon't tell the full story.
(29:25):
And for the deals that havetaken losses in the past,
they were unlucky withconcentrated bets in the wrong
sectors multiple yearsthrough multiple cycles.
And we just don't seethat happening with many
of the large managers withdiversified portfolios
and experience and dedicationmanaging these structures.
So in general, we're verypositive on double B credit
and just the structure itself, especially
(29:48):
with rising credit enhancements over time.
So we see no reason forthat to get worse compared
to those historical stats.
- Yeah, well the stats that Iquoted, by the way, those are
for the last 30 years,
but that doesn't account foris that post financial crisis,
there's actually more equityin CLOs than there was prior.
So the newer double Bsare actually the more
(30:09):
conservative ones.
And at Fire rock we like
to invest in middle market double Bs
where you get 12% equity inthe CLO instead of the 8%
or so in broadly syndicated CLOs.
So if we're talking abouta default rate requirement
to break a deal to missa dollar of interest
or principal, we see that asa 15% annualized default rate.
(30:31):
So as a result, we're very bullish on
middle market double beast.
- Absolutely.- So one other question I wanted
to ask you is just around whatare investors reaching out
to you on these days?
What are the key topics?
I assume refis and resets are the biggest,
but is there any other topicsthat are worth mentioning?
- I think that's a lot of it just refis
and resets how to modeloptionality both for equity
(30:53):
and for double Bs in lightof high reset volumes.
What are the characteristics driving refis
and resets expectationsfor investor demand,
whether it's bank regulation,whether it's overseas,
whether it's ETFs or insurance.
Some thoughts on that.
Other than that, a lot of it's macro
and thinking about interestcoverage ratios and when
and how much will affect cut.
(31:13):
You obviously have alarge share of issuers
with rate hedges on that areprobably gonna expire in early
to mid 2025,
or in other words you could say
that the median issuer probablyhas a three-ish percent base
rate right now net of hedgesin terms of SOFR for the loans.
So depending on where SOFR
and FED funds will be inmid 2025, if they don't cut,
(31:34):
that's five and threeeighths and that's an issue.
We think that the terminalfed funds rate can get down
to something like three and an eighth.
Within about two years.
The Fed could cut quarterlypotentially next year once they
start cutting and theyhave confidence to cut.
But where that fed fund
and SO FFR rate is in early
to mid 2025 will have alarge impact on credit
(31:54):
and potential downgrades asthese hedges are rolling off.
So doing analysis on that
and trying to monitorthat situation in light
of macro is anotherquestion we get pretty often
- For CLO equity.
If a deal is coming off it'soncall period in say six
months, and the capitalstack is in the money,
so meaning you could refinance it today,
if you could at a lowerrate, in your experience,
(32:16):
would a secondary buyer, wouldthey be willing to pay up for
that optionality
or is it more of aoptionality where the owner
of CLO equity has toexecute on a refinance
or reset really to get any value?
- That's a really interesting question.
I feel like if you asked me that three
or four months ago, the answer would be
very different than now.
But right now it feels like most of
(32:37):
that optionality is pretty fullypriced in for anything soon
to roll off from no-call or past, no-call,
but a few months agothe market was starting
to lean into those assumptions
but wasn't really paying for it.
So yeah, so a lot of thevaluation in secondary equity is
based on executing that refi reset
and realizing those spread savings.
Otherwise, the returns aredefinitely gonna suffer
(32:58):
- For us looking for goodcandidates where there's a refi
or a reset coming,
that's certainly somethingwe would focus on.
But on the other hand, if it'spotentially six months off,
I think you're willing to paysomething for the optionality,
but you're certainly notgonna buy CLO equity under the
assumption that when aon-call date rolls off, that
(33:20):
that magically the manageris going to be able
to get a deal done on that date.
Potentially there's a deal ahead of you
or spreads may move wider in the interim.
You don't know, so youreally can't bet on it.
I agree people are starting
to value the optionality morecertainly in the current marks
and where things trade,
but for a long time I wouldjust say there was really no
(33:41):
value given to theoptionality in these deals.
So you were highly incentivizedto look around in the market
and find deals where you thinksomething favorable could
happen in a shorter period of time.
- I think that's right.- Well, Paul,
is there anything else happening in CLOs
that we haven't covered today?
- Not really. I think we covered a lot of
what we've done in our research
(34:01):
and what's interesting to investors
minds in terms of our con.
- Great. Well, Paul, thanks so much
for coming on the podcast.
- Great. Thanks for havingme, Shyla. I enjoyed it.
- The content here is forinformational purposes only
and should not be takenas legal business tax
or investment advice or beused to evaluate any investment
(34:25):
or security.
This podcast is notdirected at any investors
or potential investorsin any Flat Rock Global
Fund definition.
Section A UM refers toassets under management,
the secured overnight financing rate.
SOFR is a broad measure of the cost
of borrowing cash overnight.
Collateralized by treasurysecurities PAR build refers
(34:48):
to building the par balanceof the CLO loans where each
that hasn't defaultedis counted at its par.
Value leveraged loans arecorporate loans to companies
that are not ratedinvestment grade broadly.
Syndicated loans areunderwritten by banks, rated
by nationally recognizedstatistical ratings organizations
and often traded by market participants.
(35:11):
Middle market loans areusually underwritten
by several lenders with the intention
of holding the investmentthrough its maturity.
Global financial crisis
or GFC refers to thebanking downturn in 2008
and 2009.
Risk retention is when the CLOmanager acquires securities
in its CLO to meetregulatory requirements.
(35:33):
Junior capital is financing
that has a lower priorityclaim in debt repayment
to a secured term loan spreadis the percentage difference
in current yields of various classes
of fixed income securitiesversus treasury bonds
or another benchmark bond measure spread.
Tiering refers to differentCLO managers being able
(35:53):
to finance their CLO at different rates.
RMBS are residentialmortgage-backed securities.
General disclaimer section references
to interest rate moves arebased on Bloomberg data.
The credit quality offixed income securities
and a portfolio is assigned
by a nationally recognizedstatistical rating.
(36:14):
Organizations such asStandard and pos, Moody's
or Fitch as an indication
of an issuer's credit worthinessratings range from triple A
highest to D lowest bonds rated Triple B
or above are consideredinvestment grade credit ratings.
Double B and below are lowerrated securities, also known
as junk bonds.
(36:35):
Any mentions of specific companies are
for reference purposes only
and are not meant to describethe investment merits of
or potential or actualportfolio changes related
to securities of those companiesunless otherwise noted.
All discussions are based onUS markets and US monetary
and fiscal policies.
(36:56):
Market forecasts
and projections are basedon current market conditions
and are subject to change without notice,
projections should not beconsidered a guarantee.
The views and opinions expressed
by the Flat Rock global speakerare those of the speaker as
of the date of the broadcast
and do not necessarily represent the views
(37:17):
of the firm as a whole.
Any such views are subject
to change at any time basedupon market or other conditions,
and Flat Rock GlobalDisclaims any responsibility
to update such views.
This material is notintended to be relied upon
as a forecast, research,or investment advice.
It is not a recommendationoffer or solicitation to buy
(37:40):
or sell any securities or toadopt any investment strategy.
Neither Flat Rock Global
nor the Flat Rock GlobalSpeaker can be responsible
for any direct or incidentalloss incurred by applying any
of the information offered.
None of the information
provided should be regardedas a suggestion to engage in
(38:00):
or refrain from any investmentrelated course of action
as neither Flat Rock Global
nor its affiliates are undertaking.
To provide impartialinvestment advice, act
as an impartial advisor
or give advice in a fiduciary capacity.
This broadcast is copyright 2024
of Flat Rock Global LLC.
(38:21):
All rights reserved.
This recording may not bereproduced in whole or in part
or in any form without thepermission of Flat Rock Global.
Additional informationabout this podcast along
with an edited transcript may be obtained
by visiting flat rock global.com.
- Hi, I'm Shiloh Beat
and welcome to the CLO Investor podcast.
CLO stands for collateralizedLoan obligations,
which are securities backedby pools of leverage loans.
In this podcast, we discusscurrent news in the CLO industry
and I interview key market players.
Today I'm speaking with Paul Nicom,
(00:24):
CLO researcher at Mura Securities.
Paul's job is to provideCLO market commentary
and analysis to CLO investors like myself.
Our primary discussion revolved
around evaluating CLOmanagers at Fire Rock.
We do not manage CLOs, wejust invest in CLO Securities.
Each CLO has a manager.
Their job is to pick the loans for the CLO
(00:47):
and to keep the CLO passing.
Its many tests according to Credit Flux.
The five largest CLO managers are Elmwood,
credit Suisse AssetManagement, Blackstone,
Neuberger Berman, and Octagon.
But CLO investors have overa hundred different managers
they can choose from Ourconversation also tackled declining
CLO financing costs.
(01:08):
And now my conversation with Paul Nico.
Paul, welcome to the podcast.
- Thanks, Shiloh. It's good to be
on. Appreciate you having me.
- Why don't you tell ourlisteners a little bit about your
background and how someonebecomes a CLO researcher? Sure.
- To be honest, I didn'tstart off as a CLO researcher.
(01:29):
I've been covering securitized products
as a research analyst since 2003,
but I started my career covering mortgages
and housing for the first decade.
So it was a really interesting time
to cover both of those markets.
Obviously saw the large runuppre global financial crisis
and then the whole mortgage market
and the housing market imploded
and then that was followedby the recovery trade aided
(01:50):
by a lot of government support
and just a slow rebuildof the mortgage market.
So it was a really interestingtime to think about scenarios
and how to stress bonds andjust experience both the boom
and the bust cycle.
And then after 2010
or 2011, it was really the recovery trade
where we saw government support come back
to the housing market and private capital
(02:10):
and really start to slowlyexpand the underwriting box.
And the mortgage market slowly came back
until the housing market accelerated
and then it was boom timesfor much the next decade.
So as we covered RMBS
and housing during that decade post GFC
and we expanded our coverage,
we started looking at other sectors
as well within the securitizedproducts research arena.
(02:32):
One of the sectors that stoodout to us was the CLO sector
that was starting to gain its footing
and starting to growpretty rapidly at the time.
And it was really interestingfor us as research analysts
to look at the performance during the GFC.
Now, the mortgage marketclearly did not do well
and it was really housing led,
but CLO market did quite wellsurprisingly well when we
(02:53):
started looking at the data.
And it was really interesting to see
how these structures held upin this first stress scenario
that we started to take a look at.
And basically around that time,our firm Nomura also decided
to make a commitment to growin the CLO business, starting
with the secondary trading
and followed by theprimary business as well.
And we started to cover the sector from a
(03:13):
research perspective.
So the idea was that wehad really great technology
that we built up from theresidential mortgage research
arena looking at loansand mortgage servicers
and intext data.
First thing we did is wetook a look at those systems
and applied them to the CLOmarket where we had managers
and we had individual loan issuers.
We tried applying similar technology
(03:35):
to see what we can find.
And it was a reallyinteresting time to start
to look at a very microlevel at the CLO market
to see differences in manager performance
and loan performanceand issuer performance.
And that's how we got started.
We were in the rightplace at the right time
and we were able to transfersome of that technology from R
and BS to really hit theground running on the CLO side.
And since then, the market hasobviously grown dramatically.
(03:57):
It's one of the key sectorswithin the securitized markets,
and it's very fascinatingto look at the market,
both from a very macro perspective
where we look at the buyerbase and overseas investors
and just supply demand dynamics
and also at a very micro levellooking at manager selection
and loans and recoveries anddrilling in very, very deep.
So it's been a very exciting time
to be a CLO research analystover this past decade.
(04:20):
- So for your research, is it
that you put out a differentpiece each week that goes
to a number of clients tellingthem whatever you think is
interesting that'shappening in the market?
- Exactly. So we try to respond to
what questions are oninvestors' minds at every week,
sometimes more frequentlythan once a week depending on
what's going on in the market.
But we try to combine some
of the micro interesting data analysis
(04:41):
and manager analysis with some
of the broader macro observations
that we find in our research.
- I know Nomura has a CLO banking team
and a CLO trading team.
Why don't you talk about the other things
that Nomura is doing with CLOs?
- So starting in 20 15,20 16, we started off
by having a very strongsecondary trading effort.
So our firm is the mostactive trading desks in most
(05:04):
scenarios in Double BS and equity
and me in general, we speakwith all the key investors
that are active in the space
and we have a very strong franchise there.
A couple years later,
we also made an investmentin the primary business
where we deal with many of the largest,
most established managers in the space.
And we've really built a top10 business in that space.
So part of it is timing andgetting the timing right.
(05:26):
Part of it is investing in talent
and investing in balancesheet as well as research.
So our firm has really decided
to make an investment in this business.
- So what is it about CLO equity
and CLO BBS that's of particularinterest to your firm?
- It's a very data intensive,research intensive product
where there's a lot of differentiation
(05:46):
and performance across managersand deals and vintages.
With the right tools in place
and the right investment inplace, we have developed a way
to find a niche and an edgein identifying opportunities.
There's a lot of dispersionin performance, so that's one.
These products trade verydifferently depending on the
profile and requires a lot of analysis
and insights into themarket to figure out how
(06:07):
to generate alpha for our clients as well
as run a successful trading business.
And part of it is connectivityto our primary business
as well, where a lot
of what's going on in themarket today has to do
with optionality for issuersand equity holders to refi
or reset or call these deals.
So having an insight into
what investors wannado both on the primary
(06:27):
and the secondary side
and what are the outs for thesedeals has a large impact on
valuations, especially given that most
of the market is trading at a premium now.
So the timing of that refirereset is also crucial.
We feel like we've developedan edge in that as well.
- Interesting. So oneof the things I wanted
to focus on today was justhow to evaluate A CLO manager.
(06:48):
So if we're talking aboutbroadly syndicated CLOs, which is
around 90% of the market,
I think there's a hundreddifferent active CLO managers.
What do you think the firststep is in identifying a CLO
manager that's gonna outperform
- From a research perspective?
We've developed a large variety of metrics
to evaluate manager performanceover a long period of time.
(07:09):
So in the past, I'd say
that par bill was the mostrelevant metric that we used.
- Note par build refers
to the CLO manager growingthe par balance of the loans.
This can sometimes bethought of as loan gains
- To benchmark and comparemanager performance over a
long period of time.
Although in recent months
and quarters, it's becomea less useful metric
(07:31):
by itself even though a lot
of managers have beenfocused on risk reduction
and defending against tails,whether it's downgraded loans
or lower price loans picking up.
And the stats have beenskewed based on the
par build metric alone.
So we've done a couple of things to try
to identify who'soutperformed in recent years.
Number one is we've tried
to improve on the par build metric.
(07:52):
And what I mean by that iswe've created a new sub metric
within par build to try
to decompose the two effectsthat drive par build.
One is original portfolio quality
or credit selection, how has
that original portfolioperformed over time,
absent any subsequent trading activity
and also the value add of trading.
So we have a metric, we like
(08:13):
to call it active versuspassive par build.
So we decompose thatperformance by manager.
That gives a lot of interesting insights.
First being that originalcredit selection matters a lot
more than trading activity
and driving performance
for many managers over the past two years.
So that's one observation thatwe rely on from this metric.
- So is what you're saying herethat the CLO begins its life
(08:34):
with 400 million or 500 million of loans
and it's really thatinitial loan selection
that's gonna be the key driver
of returns over time? That's your view?
- In the last two years,that was the primary driver
of differences in performance,
not necessarily true inprevious episodes of distress,
but over the past twoyears, definitely the case.
Another thing is looking athow CLO managers manage tails.
(08:57):
So on the surface you couldtake a look at what's the triple
C concentration by manager,
and that's one thing thatthe market does tier for.
But looking under thehood, there's some managers
that don't sell a lot of triple Cs
and they might have acredit view that some
of these loans might recover
and the market pricesare too low at the time,
and you have other managers that might be
very aggressive in selling.
And then you also have the other dimension
(09:18):
of high downgrade rates to triple C
and lower downgrade rates to triple C.
So I think it's also veryimportant to decompose
and think about what aredowngrade rate differences across
managers and how does thatinteract with trading as well?
So sources of triple C
and how managers are handling that
through the cycle alsomatters quite a bit.
And finally, just thinking more broadly,
(09:39):
consistency matters quite a bit.
So in terms of thinking aboutwho's done well in the past,
there's obviously no guarantee
that past performance willlead to future success.
So we like to look over a longtime period at consistency
throughout different cyclesand consistency and style.
But for example, some metrics we like
to take a look at are unleveredreturns on the underlying
(10:00):
portfolio over time.
So how does it look everycalendar year going back five
or 10 years depending on the tenure
of managers we're taking a look at?
So consistency is important.
If you're a debt investor,you do not wanna see large
drawdowns necessarily equity investors,
you might have a littlebit more tolerance for
that if you see moreupside in certain years,
but it all depends on whereyou sit in the capital stack.
(10:20):
So consistency in generalmatters quite a bit
as we think about forward outlook.
- So one of the things fromI see is that the metrics
that you used, I couldobviously see the attractiveness
of using them, but eachmetric is a little bit
incomplete in some way.
So for example, you mentionedthe par balance of the loans
and is it growing?
So the shortfall of thatmetric is just, well,
(10:43):
are the loans price at paror 90 or some other number?
And then if we're lookingat triple C balances,
triple C loans are certainlyat higher risk of default.
But one of the first experiencesI had with CLO managers,
I went to a prominent one
and he was telling me abouthis philosophy on triple CCCs
and he just basically said, Hey listen,
(11:04):
I'm just buying good loans for the CLOs.
And if a rating agencyhas a loan at triple C,
it's important to know thatfor the functioning of the
CLOs many tests.
But at the end of the day, he is like,
I just wanna buy good loans.
He trusted his credit team alot more than the rating agency
assessment of the risk in the loan.
And he told me he mightbuy a triple C loan
(11:26):
because it has a high spread or
because it has a low dollar price.
So sometimes the rating agenciesare a little bit lagged in
terms of their downgrades or upgrades.
So that's the downside tousing the triple C balance
as a prominent metric.
And at the end of theday, really the question
with triple Cs are justare they gonna repay at
at par or not?
(11:46):
- Yep, exactly. I think that'svery consistent with a lot
of our thoughts as well.
I think that speaks tooriginal credit selection
mattering a bit.
And obviously you wanna have amanager that's at least aware
of some of the triggers and tests
and the structural constraints
of A CLO versus just managinga loan portfolio as it relates
to certain stress scenarios
or the ability to have goodmetrics so that they're able
(12:07):
to continue to raisecapital in the future.
But at the end of the day,I completely agree it's loan
selection and having agood credit team definitely
matters quite a bit.
Those with better selectionability over the last couple
years have definitelyoutperformed in our metrics versus
those that might be optimizingpar build, for example.
- So I think the first cutfor any CLO manager analysis,
(12:29):
what we would do is justpull up their deals and Intex
- Note Intex is softwaremarket participants use
to model CLO securities
- And look for deals thatare two to three years old
and see what's happeningwith the loan portfolio.
And really just askyourself, are these CLOs
where I would've wanted toparticipate from inception?
(12:50):
I think that's a good wayto start the analysis.
One of the things that Ithink is everybody's looking
for the loss rate on the loans.
So one manager might have 40 basis points
of annualized loan losses,another might have 60
and somebody say, okay, wellthe 40 is better than the 60,
but what you really need todo is normalize for the income
(13:14):
or spread of the loans.
So if one CLO managerhas a 20 basis points
of incremental loan losses,
but their loans provide 40 basis points
of incremental loan income, then
that's the better manager in our view.
- For equity holders. That's definitely
a valid way to look at it.
I think that, for example,
our unlevered return metrichandles that maybe not directly,
(13:35):
but it goes in that direction
where if you have a higherspread on the portfolio that'll
contribute to the returns
and be offset against themarket value drawdowns.
So we don't explicitlycount defaults separately
from market value moves.
It's counted together. Andthat's a very good point
for equity that you have somemore cushion if you have a
higher spread portfolio.
So yes, absolutely, I would
definitely consider that as well.
(13:55):
- If you were just gonna use one metric
and one metric only toevaluate a CLO manager,
would it be the unleveredreturn of the loans first,
the Morningstar loan index?
So that's just the performanceof the loans outside
of the CLO structure
- Over the long term in terms
of identifying upgrade candidates
and just thinking bigpicture. Yes, absolutely.
(14:17):
- So I mentioned earlier thatthere's downsides to each way
of measuring performance,
and if you're looking at theperformance of the loans only,
you're not capturing anyof the skill that's needed
to manage CLOs and the CLOs.
Many tests. And then also someCLO managers are just gonna
have more conservative loan portfolios.
(14:38):
So those might underperformthe Morningstar loan index,
but with the leverage
provided by the CLO structure,
the returns there couldstill be quite favorable.
- Yep. I mean, one thing Iwould say for that is we tend
to look at a cluster a two bytwo scatterplot, if you will,
of returns versus standard deviation
of returns versus some other risk metric.
We've played around with a fewto risk adjust those returns
(15:00):
to do some comparative analysis.
So for the higher return,
lower standard deviationmanagers look at a quartile,
for example, on this two by two grid,
which managers areoutperforming their peers.
I agree with you. On averagethere are some biases
to looking at it that way
and it might not fullycapture the equity returns,
but we're thinking more interms of upgrade candidates
or which smaller managersare outperforming some
(15:22):
of their bigger manager counterparts
and are deserving of anupgrade for equity managers.
I think that definitely wouldlook at different metrics more
so in terms of leverage anddistributions and cushions,
but that unleveled returnversus appears is more
for a holistic view on upgrade potential
and small versus big managers
and who's trending in what direction.
(15:42):
- So maybe the takeaway isjust that there's a number
of different ways to evaluate CLO managers
and you probably need to use all of them
to really get a complete picture.
So the result of CLO manageranalysis is a tiering
of CLO managers into tier one through four
with one being the best.
So I think starting at tier four,
(16:04):
would you put anybody in tier four?
I'm not necessarily lookingfor names at this point,
but are there a handful of managers
that have really underperformed
- In terms of underperformance?
Yeah, there's probably isn't a quarter
of all the managers outstanding.
It's probably not the bottom quartile.
Maybe it's the bottom decileof, as you mentioned, managers
that haven't issued andsome of them might be trying
(16:25):
to rebrand themselves andhave much cleaner portfolios
and switch their style, butthere's definitely a few
that clearly haveunderperformed in the past
and clearly have par holes
or underperformed duringpast stress periods
that are just not treatedwell in secondary at all.
There's stats reflect that.
The other tier is justnew managers in general,
which we give them thebenefit of the doubt
(16:45):
and wait two to threeyears to see a track record
before really taking on a view.
To your point earlier
that everything looks clean on day one,
but it seems like it takesat least two to three years
of history before we couldstart to differentiate
who are the better and theworse of the new managers.
And basically who deservesan upgrade to tier one
or tier one and a half faster than others.
That's how we're thinking about it.
(17:07):
- Okay. So who do you thinkis in the top tier if you're
able to share a few names with us?
- Sure. So top tier
and the way we think about itinternally, there's a couple
of different metrics,whether you're the top,
you're the bottom of the stack,part of it's performance,
part of it is a UM, partof it is number of deals
and primary spread tiering,
and it's a little bitof a circular argument.
(17:27):
We don't really love it as research folks,
but it makes sense thatmanagers that have been
around longer who haveconsistently traded tight primary
have better liquidity.
So there's a better refi reset optionality
to get out if spreads tightenwithout as much extension risk
and they're gonna tradebetter in secondary if you see
another covid scenario andspreads blow out, for example.
(17:47):
So there's some self-fulfillingprophecy to that.
Our first blush would just be to rank
by primary spread tiering aswell as just a UM in general.
So you'd see a lot ofthe usual names there,
but to put a couplenames out there in terms
of overlaying a researchview on performance
and who's been cleaner
and who's navigated throughcredit cycles better than
others, some names that standout within that tight spread
(18:09):
and high a UM top quartilewould be, for example, Elmwood,
CSA, Oak Hill, I guess BlackRock, CISC,
Allstate are some names that come to mind.
- So do you think that mostpeople in the market would agree
with the tier one distinctionfor the guys you mentioned?
Or is it that CLO investors like myself
that we are just using totallydifferent inputs into our CLO
(18:32):
manager analysis that wouldresult in a different tiering?
- So at the top of the stack,
I think it's prettyself-evident given the A UM
and primary spread tiering,which tends to be very sticky.
And part of it has to do with the fact
that larger anchor buyerstend to just set up their list
and they tend to switch less frequently.
Although we have seen ashift in the AAA buyer base.
(18:54):
So there's some impetus for change,
although not as rapidly asat the bottom of the stack.
So at the double B
and at the equity part of the stack,
I think there's a lotmore opinions, especially
of if a manager hastails that are increasing
or has cleaned up quite a bit,the market could tier very,
very differently pretty quickly
after seeing some of theperformance differences.
Or they might tier a manager differently
(19:16):
for vintages two years agoversus four years ago based on
differences in performance.
So it feels like down the stack
that tiering is a lot more responsive
and there's a lot moreopinions about who's improving,
who's trending, who'sgetting worse, et cetera.
- So from my perspective,
it looks like a tier onestatus at the top of the stack.
For the aaa for example,a lot of that seems
(19:37):
to be just based on namerecognition rather than the
performance of the underlying loans.
And once you have thattier one AA investor base,
I think it tends to be pretty sticky.
So these guys just continue todo your deals year after year
and maybe aren't looking toput new entrants on their list.
And in CLO equity is totally different.
So you're bearing any loanlosses, it's an issue for you.
(20:00):
So name recognition doesn'treally pay the bills.
The other part of CLO manager tiering
and manager selection is just
that there could be managersout there that we really like,
but at the end of the day,
if they can't get good debt execution,
then there's really nothingfor us to talk about
because that's the key ingredient
for good CLO equity returns.
So Paul, let me ask you this.
(20:22):
It seems like every year there's five
to 10 new CLO managerentrance to the market.
Have you seen any of thosebe particularly successful?
I think it's a pretty tough business
to break into. Actually,
- This may not be the newest of managers,
but Elmwood was probably thefirst one that stuck out.
Obviously the PM came from BlackRock
and the performance waspretty similar early on
(20:43):
and conservative, butthey've performed very well
and are clearly tier one
and nobody would call them a new manager,
but they're probably thefirst one that we would think
of in terms of that upgrade cycle.
But more recently, I guessBirchgrove white box stand out
to us as also going downthat positive trajectory.
- So one of the changeswe've seen in terms
of CLO management style is
(21:04):
that pre covid managerswere doing loans with
LIOR spreads from 330basis points all the way up
to 400 basis points.
And during covid, when loanlosses were elevated, a lot
of the loan losses wereactually in the high spread
names, which makes sense.
So it was really theconservative loan pools
(21:25):
that outperformed during covid.
And it seems a lot
of CLO managers arereally now just sticking
to the lower spread pools.
Is that something you'reseeing in your research?
- I'm hearing more of the latter,
but as a research analyst,another thing that I point out is
that a few years ago,
if you take a look at a scattered plott
of was versus performance
- Note was stands for, theweighted average spread
(21:47):
of the loan portfolio
- High was tends to outperform.
In good scenarios, theytend to have large drawdowns
and bad scenarios, unsurprisingly,
but more recently, over the past two years
that correlation has broke down
and it's not obvious
that high loss hasunderperformed in the cycle.
In fact, we've seen somelower spread managers
that have had a small numberof loans that have gone bad,
(22:10):
and unfortunately therecoveries have been so low
that they've taken pretty big par hits.
So the correlation betweenhigh and low spread
and performance has reallybroken down in recent years,
and it's hard to reallyshow that relationship.
Recently just giventhe market environment,
the defaults have been low
and just the loan recovery hasbeen just very idiosyncratic.
So anecdotally, it does feellike we've seen a number
(22:32):
of higher spread managerspreviously that are trying
to go into lower spread,
more conservative portfolios rather
than the other way around.
But it's not clear thatthat has a difference,
an impact on performance as
of right now over the longerrun, in theory it's supposed
to have a correlation, but inthe last two years it has not.
- Well, one of the reasons
that we favored the lowspread loan pools was that
(22:54):
with the low spread portfolio,
you can still generatevery healthy distributions
to the equity, but you'retaking less risk on
the underlying loans.
And if the loan poolstays strong over time,
then you're the optionvalue of doing resets
and refis in the future is greater.
Whereas if you just have thehigher spread portfolio, that
(23:18):
to me implies more risk
and the higher spread, theloans do create more income
for the CLO equity thatcomes quarterly and
and of course that's nice,
but you don't really need toreach for the higher spread,
spread the loans to getvery good CLO equity returns
is is our view.
(23:40):
- Yeah, I think that makes a lot of sense.
I remember I think five
or six years ago, this iswhere we saw a switch where
before that the lower spreadmanagers didn't necessarily
have great distributions
and a lot of them wereshunned by the market.
But after that there startedto be a transition where some
of the lower spread managershad really tight funding costs
and they avoided a lot of the hiccups in
20 17, 20 18, 20 19, whether it's retail
(24:02):
or some of the idiosyncratic issues
that showed up in the loan market.
And they reallyoutperformed, at least some
of them started outperform.
And I think that trend has continued.
So I think that makes a lot of sense.
- So changing topics, one
of the things we've seen this year is
that the COO financing costs have come in
really dramatically.
And curious if you thinkthe trend's gonna continue
(24:24):
or if there's some floorlevel to SEAL Lewis spreads
that we may hit at some point?
- That's a great questionthat we often have
received recently.
I feel like spreads willcontinue to oscillate down,
but the issue is that everytime you tighten a few bips,
you could see another wall ofrefi reset supplied pickup,
and that could temporarilycause spreads to widen
(24:45):
before they tighten again.
But the general directioncontinues to be tighter.
So across all thesecuritized products assets
that I cover now,
the conversation is reallyspreads are pretty close
to post pandemic tightsor near two year tights.
And now take a look at where spreads were
before the pandemic andlook at that comparison.
And CLOs are not in a vacuum by any means.
(25:05):
I don't think that there'sanything preventing CLOs
to go into the low to midone thirties by year end
with a couple of fits
and starts where spreadsmight temporarily widen
with refi reset supply.
But there's a couple ofimportant factors here.
One, just from a broadermacro environment,
we think the macro environmentwill be relatively benign
and fund flows will bepositive and insurance
(25:26):
and annuity flows will be positive.
And more importantly, bank demand
for securities has gradually picked up.
And we think that trend willcontinue going into year end
positive for CLOs justgiven the duration profile
and the floating rate nature.
But I think all the majorinvestor groups are either
investing quite a bit
or rising as a share of buyersin terms of the CLO market
(25:46):
and broader securitized products.
Also, net issuance isvery, very limited for CLOs
and even more limitedfor triple eight given
that amortization speeds are elevated
and most of theamortization happens at the
AAA part of the stack.
So to give some context, CLOAAA net issuance is barely
above zero year to date,
whereas overall CLO net issuance is about
(26:08):
15 billion year to date.
So the net amount of growth
and the AAA part of themarket is pretty close to flat
and that'll probably continuefor the remainder of the year.
Taking a look at some of the bank data,
banks have been roughlyflat to down in terms
of their holdings over the last quarter
and they could pick up a little bit.
ETFs obviously are growing
and accelerating, especiallyat the top of the stack,
(26:29):
and it doesn't take much of ETF
or bank flows to reallypush aaas tighter given
that they're not really creating new aas.
A lot of it is recyclingfrom short to long
and amortization.
But in general, we think thetechnicals should be positive,
think the macro environmentshould be positive.
We think the Fed first ratecut, we're calling for July
with some risk that itgets pushed to September,
(26:50):
but we're calling for two cuts this year,
possibly slightly less, butat least one cut this year.
Even if some of the inflationprints are a little bit hotter
in the near term, it does feellike a risk on environment
and general spread tightening environment.
So we are positive at the top
of the stack continuing to tighten.
- Do you think that spreadtightening is really a function
of the fundamental performanceof the underlying loans
(27:13):
or is it more technical in nature?
- I think it's verytechnically driven recently,
so a year ago agency spreadsat 180 bips was certainly an
impediment to CLOs tightening given
that you saw some crossoverbuyers look at both,
that issue has gone away.
Agencies have tightened in quite a bit
and we think they are slightly below
where fair value is right now.
(27:34):
So that's one. The technical environment
of issuance is very, very limited
and the buyer base hasexpanded tremendously.
Used to be a couple ofanchor buyers in Japan
and a couple of domestic banks
sponsoring the majority of deals.
Now you have deals that are syndicated,
you have money managers, youhave insurance, you have ETFs,
so you just have much more players,
especially in retailsponsoring the sector.
(27:55):
And on the fundamental side,
we see no issues at theAAA part of the stack.
It's as positive as ever.
So we think that all signspoint to continue tightening
- Well.
I think the higher base ratehas certainly attracted a lot
of people to our market,the science CLO equity.
The other really important security
to me is the CLO double B.
So by our math, there'sbeen about 25 basis points
(28:17):
of annual defaults thereover the last 30 years.
And s and p publishes a stat on that.
I think there's about 35 different
names that have defaulted.
So it's a pretty small number.
Given the size of the overall market.
Do you think that thefavorable risk adjust returns
of BBS will continue here
or is there any reason to think
that the default rate will pickup from the 30 year history?
(28:40):
- We're very positive on double Bs.
We think it's a very stable structure.
We don't think that defaultrates will materially pick up.
Obviously there's a manager bias
where if you take a lookat some of the deals
that have taken write downs
or have not paid principal in the past
or have been downgraded todefault in the past, they tend
to be some of the smallermanagers, maybe managers
that have taken on more of the risk,
but not necessarily in thelarge top tier managers
(29:03):
that have had more of a defensive posture
and an active trading posture in general.
So overall on a modelbasis, it's extremely hard
to break double Bs.
You need to annualize thefall rate of at least five,
maybe seven or 8% per year
for life depending onyour other assumptions.
And it's like a GSC scenarioextrapolated multiple times,
but we know that averagesdon't tell the full story.
(29:25):
And for the deals that havetaken losses in the past,
they were unlucky withconcentrated bets in the wrong
sectors multiple yearsthrough multiple cycles.
And we just don't seethat happening with many
of the large managers withdiversified portfolios
and experience and dedicationmanaging these structures.
So in general, we're verypositive on double B credit
and just the structure itself, especially
(29:48):
with rising credit enhancements over time.
So we see no reason forthat to get worse compared
to those historical stats.
- Yeah, well the stats that Iquoted, by the way, those are
for the last 30 years,
but that doesn't account foris that post financial crisis,
there's actually more equityin CLOs than there was prior.
So the newer double Bsare actually the more
(30:09):
conservative ones.
And at Fire rock we like
to invest in middle market double Bs
where you get 12% equity inthe CLO instead of the 8%
or so in broadly syndicated CLOs.
So if we're talking abouta default rate requirement
to break a deal to missa dollar of interest
or principal, we see that asa 15% annualized default rate.
(30:31):
So as a result, we're very bullish on
middle market double beast.
- Absolutely.- So one other question I wanted
to ask you is just around whatare investors reaching out
to you on these days?
What are the key topics?
I assume refis and resets are the biggest,
but is there any other topicsthat are worth mentioning?
- I think that's a lot of it just refis
and resets how to modeloptionality both for equity
(30:53):
and for double Bs in lightof high reset volumes.
What are the characteristics driving refis
and resets expectationsfor investor demand,
whether it's bank regulation,whether it's overseas,
whether it's ETFs or insurance.
Some thoughts on that.
Other than that, a lot of it's macro
and thinking about interestcoverage ratios and when
and how much will affect cut.
(31:13):
You obviously have alarge share of issuers
with rate hedges on that areprobably gonna expire in early
to mid 2025,
or in other words you could say
that the median issuer probablyhas a three-ish percent base
rate right now net of hedgesin terms of SOFR for the loans.
So depending on where SOFR
and FED funds will be inmid 2025, if they don't cut,
(31:34):
that's five and threeeighths and that's an issue.
We think that the terminalfed funds rate can get down
to something like three and an eighth.
Within about two years.
The Fed could cut quarterlypotentially next year once they
start cutting and theyhave confidence to cut.
But where that fed fund
and SO FFR rate is in early
to mid 2025 will have alarge impact on credit
(31:54):
and potential downgrades asthese hedges are rolling off.
So doing analysis on that
and trying to monitorthat situation in light
of macro is anotherquestion we get pretty often
- For CLO equity.
If a deal is coming off it'soncall period in say six
months, and the capitalstack is in the money,
so meaning you could refinance it today,
if you could at a lowerrate, in your experience,
(32:16):
would a secondary buyer, wouldthey be willing to pay up for
that optionality
or is it more of aoptionality where the owner
of CLO equity has toexecute on a refinance
or reset really to get any value?
- That's a really interesting question.
I feel like if you asked me that three
or four months ago, the answer would be
very different than now.
But right now it feels like most of
(32:37):
that optionality is pretty fullypriced in for anything soon
to roll off from no-call or past, no-call,
but a few months agothe market was starting
to lean into those assumptions
but wasn't really paying for it.
So yeah, so a lot of thevaluation in secondary equity is
based on executing that refi reset
and realizing those spread savings.
Otherwise, the returns aredefinitely gonna suffer
(32:58):
- For us looking for goodcandidates where there's a refi
or a reset coming,
that's certainly somethingwe would focus on.
But on the other hand, if it'spotentially six months off,
I think you're willing to paysomething for the optionality,
but you're certainly notgonna buy CLO equity under the
assumption that when aon-call date rolls off, that
(33:20):
that magically the manageris going to be able
to get a deal done on that date.
Potentially there's a deal ahead of you
or spreads may move wider in the interim.
You don't know, so youreally can't bet on it.
I agree people are starting
to value the optionality morecertainly in the current marks
and where things trade,
but for a long time I wouldjust say there was really no
(33:41):
value given to theoptionality in these deals.
So you were highly incentivizedto look around in the market
and find deals where you thinksomething favorable could
happen in a shorter period of time.
- I think that's right.- Well, Paul,
is there anything else happening in CLOs
that we haven't covered today?
- Not really. I think we covered a lot of
what we've done in our research
(34:01):
and what's interesting to investors
minds in terms of our con.
- Great. Well, Paul, thanks so much
for coming on the podcast.
- Great. Thanks for havingme, Shyla. I enjoyed it.
- The content here is forinformational purposes only
and should not be takenas legal business tax
or investment advice or beused to evaluate any investment
(34:25):
or security.
This podcast is notdirected at any investors
or potential investorsin any Flat Rock Global
Fund definition.
Section A UM refers toassets under management,
the secured overnight financing rate.
SOFR is a broad measure of the cost
of borrowing cash overnight.
Collateralized by treasurysecurities PAR build refers
(34:48):
to building the par balanceof the CLO loans where each
that hasn't defaultedis counted at its par.
Value leveraged loans arecorporate loans to companies
that are not ratedinvestment grade broadly.
Syndicated loans areunderwritten by banks, rated
by nationally recognizedstatistical ratings organizations
and often traded by market participants.
(35:11):
Middle market loans areusually underwritten
by several lenders with the intention
of holding the investmentthrough its maturity.
Global financial crisis
or GFC refers to thebanking downturn in 2008
and 2009.
Risk retention is when the CLOmanager acquires securities
in its CLO to meetregulatory requirements.
(35:33):
Junior capital is financing
that has a lower priorityclaim in debt repayment
to a secured term loan spreadis the percentage difference
in current yields of various classes
of fixed income securitiesversus treasury bonds
or another benchmark bond measure spread.
Tiering refers to differentCLO managers being able
(35:53):
to finance their CLO at different rates.
RMBS are residentialmortgage-backed securities.
General disclaimer section references
to interest rate moves arebased on Bloomberg data.
The credit quality offixed income securities
and a portfolio is assigned
by a nationally recognizedstatistical rating.
(36:14):
Organizations such asStandard and pos, Moody's
or Fitch as an indication
of an issuer's credit worthinessratings range from triple A
highest to D lowest bonds rated Triple B
or above are consideredinvestment grade credit ratings.
Double B and below are lowerrated securities, also known
as junk bonds.
(36:35):
Any mentions of specific companies are
for reference purposes only
and are not meant to describethe investment merits of
or potential or actualportfolio changes related
to securities of those companiesunless otherwise noted.
All discussions are based onUS markets and US monetary
and fiscal policies.
(36:56):
Market forecasts
and projections are basedon current market conditions
and are subject to change without notice,
projections should not beconsidered a guarantee.
The views and opinions expressed
by the Flat Rock global speakerare those of the speaker as
of the date of the broadcast
and do not necessarily represent the views
(37:17):
of the firm as a whole.
Any such views are subject
to change at any time basedupon market or other conditions,
and Flat Rock GlobalDisclaims any responsibility
to update such views.
This material is notintended to be relied upon
as a forecast, research,or investment advice.
It is not a recommendationoffer or solicitation to buy
(37:40):
or sell any securities or toadopt any investment strategy.
Neither Flat Rock Global
nor the Flat Rock GlobalSpeaker can be responsible
for any direct or incidentalloss incurred by applying any
of the information offered.
None of the information
provided should be regardedas a suggestion to engage in
(38:00):
or refrain from any investmentrelated course of action
as neither Flat Rock Global
nor its affiliates are undertaking.
To provide impartialinvestment advice, act
as an impartial advisor
or give advice in a fiduciary capacity.
This broadcast is copyright 2024
of Flat Rock Global LLC.
(38:21):
All rights reserved.
This recording may not bereproduced in whole or in part
or in any form without thepermission of Flat Rock Global.
Additional informationabout this podcast along
with an edited transcript may be obtained
by visiting flat rock global.com.
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